Introduction
The term investing can be associated with various activities but the common aim of these activities is to make the funds invested during the time period generate more wealth. Investing should help enhance the investor’s wealth. The sources of funds to be invested include assets already owned, savings, and borrowed money. To invest requires that you save first. You forego today’s consumption. Individuals and businesses can put their money in real or financial investments.
Real investment generally involve some kind of tangible asset for example real estate such land, a house; factory, machinery, etc. Financial investments involve contracts (in paper form or e-contracts) as stocks, bonds, etc
Speculation: It involves purchasing the saleable securities whose prices are likely to increase rapidly within a short term horizon so that they get a quick profit. Speculators are always looking for and buy at low prices and sell at dear ones.
Types of investors: Two types of investors: individual and institutional investors. Individual investors (sometimes called retail investors) are individuals investing on their own. Institutional investors are entities such as commercial banks, insurance companies, investment companies, pension funds and other financial institutions.
Types of investing & alternatives for financing
Direct investing: Direct investing is where the investor buys financial assets directly from the financial markets. Such investors who invest directly through the financial markets take all the risk.
Indirect Investing: Indirect investing involves financial intermediaries (financial institutions as brokers or agents). Under indirect investing, individuals buy and sell financial assets or instruments of financial intermediaries (the financial institutions) which always investment large pools of funds in financial markets; and hold their portfolio.
Direct transactions: Investors can bypass both financial institutions and financial markets and perform direct transactions; for example by lending.
Investors may also invest in physical assets. However, investing in physical assets may pose some challenges. While financial assets are divisible (an investor can buy or sell a small portion of it), physical assets are not. Marketability (or liquidity) is usual for financial assets. Physical assets have low liquidity.
Types of investing & alternatives for financing
The investment environment: can be defined as the available investment vehicles in the financial market for the investor and the places for transactions with these investment vehicles.
Financial markets: are a set of arrangements that allows buyers and sellers come to exchange or trade in various investment vehicles. In the financial markets, investors trade their financial assets to those requiring them.
Functions of financial markets: According to Fabozzi (1999), financial markets provide three important economic functions in an economy:
- Financial markets determine the prices of assets traded through the interactions between buyers and sellers.
- Financial market provides a liquidity of the financial assets
- Financial markets reduce the cost of transactions by reducing explicit costs. Explicit costs such as money spent on advertising of offers to buy or sell a financial asset.
Primary and secondary markets
Primary markets: This is where individuals, companies and government entities can raise capital and where the first transactions with newly issued securities are performed. This is where company can issue and sell an initial public offering (IPO) is trade for the first time
Secondary markets: This is where previously issues securities are traded among the investors. These markets include the security or stock exchanges, over-the-counter markets, and the alternative trading system (an electronic trading mechanism).
The main types of brokers are the discount brokers; full service brokers; and online brokers. An Online broker is a brokerage firm that allows investors to buy or sell electronically via the internet. A discount broker only represents players in the secondary market.
Money market and capital markets
Money market: This is a market where only short term financial instruments are traded.
Capital market: Only long term financial instruments are traded. In this market, firms, and governments are allowed to finance spending in excess of their current incomes.
The capital market and stock exchange
What is capital market?
The capital market should not be viewed as a single institution. It is comprised of all the institutions (including banks, insurance companies, pension funds, and other financial intermediaries) which are concerned with either the supply of or demand for long term funds or securities – which are claims on capital. It is therefore the market for long term loan able funds.
What is the stock exchange?
The stock exchange is where buying and selling of securities takes place. It has been referred to by John M. Keynes in his “General Theory” as a casino. That it is a place of much speculation (like a casino) where dealers are mainly interested in making immediate capital gains via buying securities at one price and selling at another.
Money markets & capital markets compared
Investment vehicles
- Short term investment vehicles
- Fixed income securities
- Common stock
- Speculative investment vehicles
- Other investment tools e.g., life insurance, pension funds, hedge funds, etc.
The investment management process
It can be summarised in a 5-step procedure:
- Setting the investment policy
- Analysis and evaluation of investment vehicles
- Formation of diversified investment portfolio
- Portfolio revision
- Measurement and evaluation of portfolio performance
Theory of Investment Portfolio Formation
The modern portfolio theory: The Markowitz portfolio theory: This approach looks at portfolio formation by considering the expected rate of return and risk of individual stocks, and their interrelationship as measured by correlation.
Capital Asset Pricing Model (CAPM): was developed by W.F.Sharpe in 1964. CAPM simplifies Markowitz’s Modern Portfolio theory and makes it more practical. Measuring risk in CAPM is based on the identification of the two key components of total risk (systematic risk, and unsystematic risk) as measured by variance or standard deviation of return.
Arbitrage Pricing Theory (APT): was proposed by Stephen S. Ross. It is now a widely applied investment tactic. Arbitrage can understood as the earning of riskless profit by taking advantage of different pricing for the same assets (or security).
Market efficiency theory: was proposed by Eugene Fama (1965). The theory of market efficiency states that the price which the investor is paying for the financial asset has to fully reflect fair and true information about intrinsic value of this specific asset or fairly describe the value of the company that has issued this security
INVESTMENT OF STOCKS
Stock represents part of ownership in the firm (Common stock = Common share = Equity in the issuer’s organization).
The main features of the common stock:
Basically each common stock owned by an investor entitles them to one vote in corporate shareholder’s meeting; Investors enjoy benefits in form of dividends, capital gains or both; Common stock has no stated maturity. (However some corporations pay cash to their shareholders by purchasing their own shares; referred to as share buyback.
It should be recorded here that:
Usually the firm does not pay all its earnings in cash dividends; Dividends are paid to shareholders only after other liabilities such as interest payments have been settled; There is a special form of dividend is stock, in which the corporation pays in stocks rather than cash.
Common stocks generally provide a higher return (but have higher risk). An investor earns capital gains when they sell at a higher price than the purchase price. A capital gain is the deference between the purchase price and selling price.
The main advantages of investing in common stock
- Common stock has a very high liquidity and can easily be moved from one investor to another
- The income from such investment is higher
- The invest has a chance of receiving operating income in cash dividends
- The transaction costs involved with common stock are relatively low
- The nominal price for a common stock when compared with other securities is lower.
The main disadvantages of investing in common stock
- The operating income is relatively low because the main income is received from capital gains – i.e. the change in stock price.
- Common stock are more risky when compared with other securities
Analysis of common stocks : the E-I-C analysis
The E-I-C analysis
- E – (Macroeconomic) Economic analysis: this is a macroeconomic analysis which the macroeconomic situation in the particular country and its potential influence on the profitability of stocks.
- I – Industry analysis: evaluating the situation in the particular industry or economic sector and its potential influence on the profitability of stocks.
- C – Company analysis: financial evaluation of the individual companies from the shareholder approach.
Market Asset Valuation
Investment of bonds
The main example of long-term debt securities are bonds. can be issued by governments, municipals and cities, companies or agencies. Preferred stock is attributed to the fixed income securities because its dividend payment is fixed in amount and known in advance. The major difference between bonds and preferred stock is that for preferred stock the payment flows are infinite (for ever), once the preferred stock is not callable.
Bonds identified by the following characteristics:
- They are typically securities that are issued by a corporation or governmental body for a specified period. Bonds are due for payment at maturity when their face value (par value) is returned to the investors.
- They usually pay fixed period instalments – called coupon payments. There are some bonds which pay variable income.
- When the investor buys a bond, they become a creditor of the bond issuer. The buyer does not gain any kind of ownership rights to the issuer property or physical assets – unlike the case with equity securities.
Evaluating the factors influencing investing in bonds
Quantitative tools:
Quantitative methods use quantitative indicators to evaluate the situation of the firm issuing the bond. Quantitative indicators are financial ratios which allow assessing the bond issuing firm’s financial situation, debt capacity and its credibility. Assessment of the credibility of the issuer is important because bonds are debt instruments and the investor in bonds becomes a creditor to the issuing firm.
Qualitative tools:
Qualitative indicators measure the subjective factors influencing the credibility of the company; which ultimately influence the investor’s decision to invest in bonds of an issuing company. These factors are qualitative not less important. Oftentimes these qualitative measures are the dividing line between effective and ineffective bonds.
Psychological aspects in investment decision making
- For a long time, and basing on economic theory, the finance and investment decisions have been thought to be based on only rational decisions and that they are usually unbiased in their predictions about the future.
- All the investment theories including the modern portfolio theory were developed basing on rational decision making by investors.
- In real life, people sometimes make irrational decisions and they make mistakes in their forecast of the future. They at times make emotional choices. Since investors are people, they do sometimes act irrationally in making investment decisions.
- In economics human beings are assumed to always take rational decisions (not emotional ones). That human beings make their choices based on rational factors.
Over Confidence
Negative outcomes of overconfidence
- Overconfidence causes investors to misinterpret the accuracy of the information and even overestimate investor’s skills in analyzing it. This usually occurs after people have first registered some success.
- Such people tend to believe that successes are a result of skill and that failure is simply bad luck.
- Overconfidence may lead investors to poor trading decisions which are usually exhibited as excessive trading, risk taking and ultimately resulting in portfolio losses.
- Overconfident investors tend to increase the amount they trade because overconfidence causes them to think that they are certain about the markets and their opinions.
- An investor may face high commissions as a result of excessive trading. High commission costs are not the only problem caused by excessive trading to an investor. It also leads to other losses because overconfidence leads to trading too frequently and at times purchasing the wrong stocks.
- Overconfidence tends to affect investors risk-taking behaviour; and they become somewhat irrational. Investors tend to believe in the accuracy of their forecasts increases with more information they are accessing.
- The more an investor registers successes, the more they will attribute it to their own ability – even where much has been involved. This explains why overconfident behaviour is more common in bull market than in the bear markets (see Gervais, S., and Odean, T., (2001), “Learning to be overconfident”, The Review of Financial Studies, 14, No.3, July, 411-435.
Market bubble:
A situation when high prices seem to be generated more by trader’s optimism (investors) in the market than by factors responsible for the growth of the economy.
Speculators in the future price or value of land or housing for example may make them pay high prices for them thereby hiking the price and the demand.
Once other investors have seen the rising demand and price in the given asset, they will also be attracted.
The result is that everyone investor has put their money in this asset, and consequently there are no more people looking to buy it. So eventually it price and demand falls drastically. This is the bubble.
Disposition effect
Fearing regret and seeking pride causes the investors to be predisposed to selling potential stocks with growing market prices (referred as selling winners) too early keeping stocks with negative tendencies in market prices (referred riding losers) for too long.Shefrin and Statman (1985) were the first economists to show this effect which is called the disposition effect. People usually want to avoid actions that create regret and seek those actions that cause them pride. Seeking pride, as they avoid regret, affects people’s behaviour; and therefore their investment decisions too. Several empirical studies have provided evidence supporting the fact that investors behave in a manner more consistent with the disposition effect. Regret can be defined as the emotional pain that occurs to people after realizing that their previous decision turned to be a bad one. Pride can be defined as the emotional joy that occurs to people after realizing that their previous decision turned well.
